In conjunction with their respective governments, central banks have been manipulating economies for decades. Central bankers have sought to control interest rates, inflation and credit through their policies. Their efforts have impacted the stock market, job creation, home construction and many more aspects of the economy. However, in recent years, central bankers have manipulated themselves into a corner and become trapped in the mess that they made.
Why Are Central Banks Trapped in Their Own Mess?
To understand the trap, it is important to understand how the central bank works. The United States created the Federal Reserve System in 1913 after several financial panics revealed that a centralized control over the monetary system was needed. The Federal Reserve Act stated three primary objectives for U.S. monetary policy, which were to stabilize prices, maximize employment and controlling long-term interest rates. In later years, the Federal Reserve was also assigned additional duties, including maintaining a stable financial system and regulating banks.
The Federal Reserve does not print money. The U.S. Treasury Department controls the actual printing of currency and minting of coins. However, the Treasury Department produces Federal Reserve Notes that are sold to the Federal Reserve in exchange for Treasury securities. The Fed collects interest on these securities, including those that it holds as collateral. The Fed also purchases mortgage-backed securities and government bonds from private sources, primarily the major Wall Street banks. The securities and bonds appear on the Fed’s balance sheet, which has increased to more than $4 trillion from $900 billion in 2009, according to the San Diego Free Press. If the Fed were to sell or redeem the government bonds it holds, interest rates would likely rise, increasing the amount that the government would face to make interest payments on its debt.
Why the Fed Wants to Keep Interest Rates Down
Theoretically, interest rates could rise to the point that the United States could face interest payments that consume all or most of the federal budget. However, this is far from the only reason that the Fed has been reluctant to raise rates. Low interest rates make it more affordable for consumers to finance homes, automobiles and other high-value assets. In turn, this spurs the economy, which typically means that unemployment rates decline. Furthermore, the low rates offered on traditional savings accounts entices consumers to invest in the stock market to obtain greater returns, especially if they are attempting to build a retirement account.
Impacts of Central Bank Intervention
The attempts of central bankers to prop up their economies have had some devastating impacts. An article appearing on ArmstrongEconomics.com states that the artificially low rates have devastated pension funds and severely impacted the standard of living among the elderly. These sentiments were echoed by Glenn Stevens, the governor of the Reserve Bank of Australia, which indicates that the issue is not confined to the United States.
The policies of the central bankers have also had a devastating impact on the bond market. An article in Bloomberg states that “yields on $7.8 trillion of government bonds have been driven below zero” and that the central banks are making matters worse by making massive purchases to prop up their economies. The author suggests that the fact that investors continue to buy bonds even when returns are currently “next to nothing” indicates that they are very concerned about global economic conditions.
The Fed Faces a Dilemma Without a Pain-Free Solution
Economists are in almost complete agreement that the Fed must raise interest rates. The low rates have not had the desired benefits, but they have had some devastating consequences. However, raising rates will also have some painful results. Wall Street bankers could short the stock market and drive values down. The unsophisticated investor might panic and dump their stocks on the downswing, but the boys on Wall Street could make a killing. As the market drops to its lowest point, the big investors will go back to buying, driving up the market.
Higher interest rates will likely slow economic activity by discouraging sales of real estate, cars or other big-ticket items. In the United States, consumption accounts for 70 percent of the gross domestic product, or GDP, so reducing consumption typically triggers or worsens a recession.
As an article on MarketWatch.com points out, the problem is that central banks are caught in a vicious cycle. If they raise rates, financial supplies tighten up, the economy declines and the stock market suffers. The typical response from the central banks has been to drop rates, resulting in looser financial conditions and improved market values. At some point, however, it will be necessary to raise rates, so the cycle continues, and no one seems to have an effective exit strategy.
What the Central Banks Will Attempt Next
Central banks are running out of tools that they can use to bolster an ailing economy. Although most analysts believe that the Fed will announce a rate hike in December 2016, there is no guarantee that it will do so. It is also impossible to predict what the Bank of Japan, the European Central Bank and other national banks may do. However, the European Central Bank as well as the Bank of Japan appear to be embracing the policy of qualitative easing. If you would like to learn more about the world’s central banks, visit the Personal Money Store.